~ Investment Strategy

Morning Note 03/01/12

Last week I posed a question: why did the ECB’s 3-year LTRO have a calming effect on the markets? I suggested three reasons:

1. It is all about small banks.
2. It is all about collateral.
3. It is all about the term.

Last week’s Economist, which I read over the weekend, gives support to all three interpretations. Drawing on work by Morgan Stanley, it points out that more money was lent to European banks than expected by the market — suggesting that some banks faced significant funding pressure — which suggests a combination of 1. and 2. Of course, I knew the facts here, and reported them at the time, but macro is all about seeing the facts in the right light. The article also points out that the average maturity of ECB lending to banks increased from a mere 10 weeks to 21 months. This is a significant lengthening of the maturity, and it gives support to 3 (it is not that there is a qualitative difference between a 1-year and a 3-year LTRO; it is that the quantitative difference in term was bigger than I appreciated). Thus I suspect that the reason for the calming of markets is a combination of 1., 2. and 3., but mainly 3.

It is possible that the ECB’s action is a watershed moment. With the economic backdrop looking more positive in the US and China, and the European crisis apparently under control for the time being (although I expect resurgence in due course), the factors that have been weighing on the markets are removed. It may be that the ECB’s emergency funding will be the match that sets this tinder-box alight, with the EUR used as a funding currency for pro-risk trades around the world. And there is still another unlimited offer of 3-year liquidity to come. If a combination of a lukewarm global economy and quantitative easing in the US pushed asset prices up in late 2010, action in the Eurozone that amounts to the same thing should have the same effect.

Thus the question becomes: is the ECB’s action akin to quantitative easing? The obvious difference is that it does not guarantee that bonds will be purchased with the newly-created base money; but on the other hand, since banks have to post collateral for their loans, securities amounting in value to more than the total loaned out (because of the haircuts applied to them) are taken out of circulation and locked up at the ECB, so the effect is the same. It is true that the banks might mostly have switched from one funding source to another; but on the other hand, there is no guarantee that the banks who sell securities to the Fed in the course of its QE operations will make new loans rather than shrinking their balance sheets. The fact is, however, that they have done so. What is more, the ECB appears ready to act as lender of last resort to the Eurozone banking system, and, crucially, not at a penal rate (as Bagehot demands) and to any extent required by the banks. That would seem, even more than QE, to give the banks permission to play rather than to retrench.

The fly in this (rather expensive) ointment is the requirement that banks increase their capital ratios to meet the requirements of European regulators — effectively a monetary tightening of a kind used by the Chinese. They seem inclined to do this by disposing of assets, something that should disrupt any flow of money into financial or any other markets. Were it not for this problem, it would be hard to resist the argument for a long position in risk assets and a short position in EUR. As it is, it seems possible that the raising of capital ratios will be a serious constraint. The next thing I need to do is to investigate this question.

Bloomberg has a story that says that “hedge funds” are a short EUR as they have ever been. The basis for this is the Commitment of Traders (COT) report, which shows a large non-commercial net short position. I have said in relation to the commodity markets that I think that movements in the non-commercial net long position reflect the activities of long-term trend followers (be they systematic or discretionary). Today I have had a look at some figures, and found that there is a high correlation between the net long position and the market price in the oil (R2=0.57) and copper (R2=0.75) markets based on weekly data for the past year. However, I am a little surprised to find a relatively strong relationship (R2=0.51) between the net long position and the price of EUR futures. I am surprised because the FX markets are less inclined to strong trends than the commodity markets, and certainly simple trend-following systems are less successful in currencies that in commodities. Either some people have found that more sophisticated systems work well, or else the trend-following speculators in currencies do not make money; I suppose that either is possible. Either way, these observations support my view that most position traders are trend followers, and that that the COT net long position should follow movements in the market price.

I remembered this morning that I had an opponent in my short EUR/USD trade. I observed on 21st October that Goldman Sachs had predicted an appreciation of EUR/USD (as reported by Bloomberg). It is always nice to win.

Data:

China PMI 50.3 b.e. An improvement and a positive surprise for the market, but this remains a weak number for the normally cyclically-strong month of December. January and February tend to be weak on account of the Chinese Spring Festival.
Australia PMI rose to 50.2 after months below 50.
German PMI was revised up from the flash estimate, b.e.
Eurozone PMI 46.9, as the flash estimate.
Swiss PMI edged above 50.
UK PMI 49.6, b.e. and increased.
All in all, the latest global PMI’s show improvement at the margin.
Regional surveys in the US suggest a small increase in the PMI. My model is consistent with a number in the mid-50’s.
German unemployment fell more than expected.